Case #5.

7 Qwest: Occurrence of Revenue

I. Technical Audit GuidanceTo maximize the knowledge acquired by students, this book has been designed to be read inconjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB AuditingStandards that are referenced in this book are available for free at:http://pcaobus.org/Standards/Pages/default.aspx.In addition, the AU Sections that are referenced in this book are available for free at:http://pcaobus.org/Standards/Auditing/Pages/default.aspx. Finally, a summary of the provisionsof the Sarbanes-Oxley Act of 2002 is available for free at:http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Summary+of+the+Provisions+of+the+Sarbanes-Oxley+Act+of+2002.htm.II. Recommended Technical KnowledgePCAOB Auditing Standard No. 5Paragraph #28-30Paragraph #39-41Paragraphs #A4 (in Appendix A)III. Classroom HintsThis case provides students with an opportunity to appreciate the difficulty associatedwith applying the rules of revenue recognition to a complex set of economic transactions (i.e.,the IRU swap transactions recorded as revenue by Qwest). To properly do so, students are ableto see that an auditor must first understand the true economic substance of a transaction. Aftergaining this understanding, the auditor must then determine whether the client has identified andproperly applied the correct technical accounting guidance. Of course, this determination mustbe made based on sufficient and competent evidence. Thus, the auditor must take steps toexercise due professional care in gathering such evidence. In addition, the case provides amechanism to illustrate the importance of identifying relevant financial statement assertions andidentifying the related control activities that are designed to support reliable financial reportingin the post-Sarbanes audit environment.

We believe it is essential for students to carefully read over the recommended technicalknowledge, along with this case reading. The educational psychology literature suggests that theacquisition of technical/factual type knowledge increases dramatically when such knowledge canbe applied in a realistic context. Thus, we urge instructors to use this case as a mechanism toimpart the relevant post-Sarbanes technical audit knowledge, outlined above.This case assignment will work best if is scheduled to coincide with the audit evidencetopic or when instructors cover the revenue process in the audit class. Regardless of when thecase is covered, we recommend that instructors spend time in class reviewing the nature of anIRU swap transaction. This is a difficult economic transaction and students are likely to havetrouble conceptualizing the transaction flow on their own. As a result, we believe that thisprovides a terrific opportunity for instructors to stress the importance of fully understanding theeconomic substance of any transaction being audited. There are absolutely no shortcuts. Theonly possible way to determine whether an audit client is properly accounting for a transaction isto first understand the nature of the economic transaction in detail. This discussion can beaccomplished quite effectively while going over the response to question #1 in the case.Importantly, the goal of the previous discussion is not necessarily to make sure thatstudents are experts in IRU swap transactions. Rather, we believe that it is important to point outto students that they will encounter difficult economic transactions as an auditor. So, when sucha transaction is encountered, students must take the time to fully understand the economicsubstance of that transaction. The professional judgment that is involved in auditing such acomplex transaction also provides an opportunity for instructors to remind students of theimportance of being unbiased and objective when making their audit judgments. Indeed, webelieve that it is helpful to remind students at this point of their responsibility to maintain an

attitude of professional skepticism throughout the audit process. Indeed, one of the primarygoals of the Sarbanes-Oxley Act of 2002 was to take steps to improve the independence andobjectivity of the audit process (e.g., Section 201). As such, we encourage instructors to take thisopportunity to remind students of this responsibility.This case also provides an opportunity to highlight the importance of identifying therelevant financial statement assertions about a significant financial statement account, a criticallyimportant task in the post-Sarbanes environment. The discussion of student responses toquestion #2 provides instructors with an opportunity to discuss this point. In addition, thediscussion of student responses to question #3 provides an opportunity for instructors tohighlight the importance of being able to identify an internal control activity that is explicitlydesigned to support reliable financial statement reporting for a particular financial statementassertion. Once again, the knowledge required to link an internal control activity to the financialstatement assertion is essential in the post-Sarbanes audit environment. Thus, we encourageinstructors to take the time to make this linkage explicit for students in the present context.Finally, since the prevention and detection of fraud is so important, the discussion of studentresponses to question #4 provides an opportunity for instructors to discuss specific controlactivities that are designed to prevent and/or detect fraud.Overall, a key premise of this book is to help simplify the relationship between acompanys internal control system and the financial statement account balances. Section 404 ofSOX made clear that this relationship is paramount.

However, the knowledge needed to

explicitly link a specific internal control activity to a relevant financial statement assertion is noteasy to impart. We therefore encourage instructors to allocate an appropriate amount of time tothis topic and to use multiple different cases to help illustrate your points. In our experience, it is

very difficult for audit students to make the connection between an internal control activity and arelated financial statement assertion. So, please consider assigning at least 2 or 3 (and perhapseven 4 or 5) cases from section 5 of this book to provide the repetition that is needed for studentsto master this important topic. It is hoped that such repeated task performance will help to bettersensitize students to the importance of internal control activities in helping to prevent and/ordetect fraudulent financial reporting.IV. Assignment Questions & Suggested Answers1. Describe why the recognition of revenue for IRU swaps for fiber-optic assets thatwere not actually needed by Qwest is inappropriate under GAAP. As an auditor,what type of evidence would allow you to determine whether the recognition of thisrevenue would be appropriate under GAAP?The recognition of revenue for IRU swaps for assets that are ultimately not used by Qwest isnot appropriate under GAAP because correct recognition requires that Qwest does have alegitimate business need to purchase the assets. According to the case information, Qwestessentially used the revenue recognized through the swap transactions to increase revenue andmeet quarterly revenue targets. In many of the instances, Qwest did not even use the assets thatit had purchased and could not resell them, rendering such assets worthless. In other cases,Qwest returned the unused assets back to the customer more than six months after the fact.In determining whether the recognition of revenue would be appropriate under GAAP, anauditor would first want to understand the common practices for swap transactions within theindustry. Importantly, the case information reveals that Qwests accounting practices for swaptransactions were aggressive, as compared to industry standards. Also, an auditor shouldconsider a review of the Board of Directors minutes to determine the economic basis, if any, forthe swap transaction. In addition, an auditor should seek to examine documentary evidence foreach individual swap transaction. The goals of this examination would be to determine whether

the economic substance of the transaction was properly captured, in accordance with GAAP.Finally, an auditor should consider reviewing a detailed summary of Qwests fixed assets tosearch for duplicate assets. And, if a duplicate is identified, the auditor should carefully discussthis finding with members of the network planning department. According to GAAP, the assetpurchased must be for a legitimate business need.2. Consult Paragraphs 28-30 of PCAOB Auditing Standard No. 5. Identify onerelevant financial statement assertion related to the revenue account that isimpacted by an IRU swap. Why is it relevant?Among other matters, paragraphs #28-30 of PCAOB Auditing Standard No. 5 focuses theauditors attention on the importance of identifying each of the relevant financial statementassertions related to significant accounts and disclosures. Indeed, the identification of relevantassertions is a critical component of the audit of internal control over financial reporting.Specifically, according to Paragraph # 28, relevant assertions are those financial statementassertions that have a reasonable possibility of containing a misstatement that would cause thefinancial statements to be materially misstated. In paragraph #30, auditors might determinethe likely sources of potential misstatements by asking himself or herself what could gowrong? within a given significant account or disclosure. It is clear that certain financialstatement assertions are more relevant than others for a particular set of financial statements.In this situation, one of the relevant financial statement assertions related to the revenueaccount impacted by an IRU swap would be existence/occurrence. The big question related tothe IRU swaps is whether the swaps should have been recorded as revenue in accordance withGAAP. Since the facts reveal that Qwest did not have a legitimate business need for the assetsthat it acquired during the swap transactions, the company appears to have engaged in theseswaps to merely generate additional revenue to meet their aggressive revenue targets. This is

also indicated by the timing of the transactions. The facts of the case reveal that managers wouldoften complete these swap transactions frequently at the close of a quarter in order to meetrevenue expectations.3. Consult Paragraphs 39-41 and Paragraph A4 (in Appendix A) of PCAOB AuditingStandard No. 5. For the assertion identified in Question 2, identify a specific internalcontrol activity that would help prevent a misstatement related to the recognition ofrevenue for IRU swaps.According to Paragraph #39, the auditor should test those controls that are important to theauditor's conclusion about whether the company's controls sufficiently address the assessed riskof misstatement to each relevant assertion. As a result, it is very important that the auditor takethe time to explicitly link internal control activities to the financial statement assertions beingsupported. In paragraph #41, the auditor is provided guidance about the controls that should betested. According to the standard, the decision as to whether a control should be selected fortesting depends on which controls, individually or in combination, sufficiently address theassessed risk of misstatement.The bottom line is that the auditor should clearly link individual controls with thesignificant accounts and assertions to which they relate. Clearly, there are a number of allowableanswers to this question. Importantly, this question is also designed to help the studentsunderstand the differences between preventive controls and detective controls and the importanceof each in a well-functioning internal control system. One example of a preventive controlfollows.For the assertion of existence/occurrence, a specific internal control procedure that wouldhelp to prevent a misstatement related to the recognition of revenue for IRU swaps would be toimplement a policy requiring that the network planning department authorize all IRU swap

transactions (to ensure that there is really a need for the asset). This control procedure wouldprevent senior management from acquiring duplicate or unneeded assets in swap transactions.4. Consult Paragraphs 39-41 and Paragraph A4 (in Appendix A) of PCAOB AuditingStandard No. 5. For the assertion identified in Question 2, identify a specific internalcontrol activity that would help detect a misstatement related to the recognition ofrevenue for IRU swaps.According to Paragraph #39, the auditor should test those controls that are important to theauditor's conclusion about whether the company's controls sufficiently address the assessed riskof misstatement to each relevant assertion. As a result, it is very important that the auditor takethe time to explicitly link internal control activities to the financial statement assertions beingsupported. In paragraph #41, the auditor is provided guidance about the controls that should betested. According to the standard, the decision as to whether a control should be selected fortesting depends on which controls, individually or in combination, sufficiently address theassessed risk of misstatement.The bottom line is that the auditor should clearly link individual controls with the significantaccounts and assertions to which they relate. Clearly, there are a number of allowable answersto this question. Importantly, this question is also designed to help the students understand thedifferences between preventive controls and detective controls and the importance of each in awell-functioning internal control system. One example of a detective control follows.A specific internal control procedure that would help to detect a misstatement related to therecognition of revenue for IRU swaps would be to have the internal audit department completeprocedures to monitor whether any swap transactions involved duplicate or unneeded assets.This control would then help detect if revenue was improperly recognized.